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Its decision to keep its currency pegged to the euro meant it had to go through a painful process of internal devaluation―cutting wages and prices―as a means to restore competitiveness and growth.

Today, three years later, Latvia has successfully completed its IMF and EU-supported program. The peg remains intact, international reserves have recovered, and Latvia regained access to international capital markets in 2011, issuing a $500 million bond. The fiscal deficit is now much lower, and the country is within reach of qualifying for euro adoption. The economy grew by some 5 percent in 2011, led by a rebound in exports. For 2012, the IMF is now forecasting growth of 1.5 percent, although that forecast is subject to considerable uncertainty because of the crisis in the eurozone.

In an interview, three people closely involved in Latvia’s IMF-supported program during the past three years―IMF mission chief Mark Griffiths, resident representative David Moore, and mission team member Magnus Saxegaard―discuss Latvia’s achievements and look at the challenges that are still ahead.

IMF Survey online: Latvia was one of the first countries to seek IMF support during the global financial crisis. Now, three years later, the economy is growing again and the program has ended. As mission chief for the past 3 years, what do you regard as the main achievements of the program?

Griffiths: The last few years have been incredibly challenging, but through their program the Latvian government and the Latvian people have made considerable progress in stabilizing the economy and restarting growth.

First, Latvia’s economy is now much less vulnerable. Current account deficits, which used to be over 20 percent of GDP, are now much lower: in 2009 and 2010 the current account was actually in surplus. The banking system is much more stable. Latvia has had problems recently with the failure of a local bank, Latvijas Krajbanka. But even though we believe the situation could have been handled better, it was not as destabilizing as when Parex Bank went bankrupt in late 2008.

Second, the exchange rate peg has survived. At the start of the program, many feared that if Latvia’s peg fell, others would fall too, spreading the crisis from Latvia to the rest of central Europe. So Latvia’s strong efforts back in 2008 and 2009 helped protect central Europe from contagion.

Third, Latvia used its international support program to implement huge fiscal adjustment― over the program period, expenses were cut and revenues raised to the tune of about 15 percent of GDP. Many doubted such a huge adjustment would be possible, but Latvia managed. Financial support from the IMF and the European Commission was crucial, but Latvia did not waste this money. Instead, the government seized the opportunity to implement important structural reforms and adjust.

Finally, I am very proud of our work with the World Bank to strengthen the safety net. Had it not been for these joint efforts with the government, the crisis would have been even harder on vulnerable groups, especially the poor and the unemployed.

IMF Survey online: Is it possible to speak of success when unemployment is close to 15 percent, and the economy still is nowhere near recovering from the steep GDP decline it experienced in 2008-2009?

Moore: A balanced assessment should reflect both Latvia’s hard-won achievements and that Latvia still suffers from high unemployment, with poverty rates and measures of inequality among the highest in the European Union. Output remains well below pre-crisis levels, but this was probably unavoidable given how large the imbalances were before the crisis, and since much of the rapid growth during the boom was unsustainable.

But Latvia turned the corner some two years ago. The economy has since grown steadily, and last year’s third quarter numbers were strong, so growth in 2011 could be somewhat above 5 percent. And inflation appears to have peaked. We expect slower growth this year because of problems elsewhere in Europe, but Latvia has done its part.

IMF Survey online: The IMF stressed the need to protect social spending even with severe budget cuts in other areas. Do you think it made a difference to how much vulnerable groups were impacted by the recession?

Griffiths: The Fund paid a lot of attention to the social safety net because we feared that unemployment would increase dramatically, based on the experience of other crisis countries―Asia in the late 1990s, and Turkey in 2001. The hardest hit sector was real estate and construction, where a lot of people lost their jobs and are not able to find new work.

We have worked closely with the World Bank to find ways to protect the poor. Under the program, the government has increased guaranteed minimum-income payments, abolished healthcare co-payments for the most vulnerable, increased funds for emergency housing support for low-income households, and protected schooling for 5–6 year olds. We also encouraged the government to introduce a public works program, financed by the European Social Fund, to give jobs to people who wanted to work but were unable to find employment.

It’s important that the Latvian government does not phase out these programs too quickly. Although they were seen as emergency measures, unemployment remains at close to 15 percent, and Europe is at risk of recession. For these reasons, it will take a long time for Latvia to lower its unemployment rate to the 6 percent we saw in the boom years, and the social safety net will remain important.

Instead, we would like to encourage the government to think of ways to make the safety net permanent, but in such a way that avoids “poverty traps”, that is, so that the system does not penalize people if they go back to work. The right system, with tax incentives for work, is not easy to design. We hope that the Latvian government will work on this with the Fund, but also with experts from the World Bank and the European Commission, and make use of the institutions’ technical expertise even though the program is now formally over.

IMF Survey online: How exposed is Latvia to the crisis in the eurozone?

Moore: As our Managing Director recently warned, no country is immune in the current crisis. Developments in the European Union and the eurozone are bound to affect Latvia. Latvia pegs its exchange rate to the euro, roughly half its exports go to the eurozone or to countries pegged to the euro, so the country’s economic future is closely intertwined with that of the European Union as a whole.

On the positive side, Latvia’s policy efforts during the past few years—as well as efforts by Latvian businesses to restructure and adapt—have kept the country relatively insulated from these recent tensions. Unlike three years ago, Latvia’s credit default swap spreads are broadly in line with those of other central and eastern European countries, and well below those of the crisis countries in the euro area—so Latvia is much better placed to cope with the current uncertainties.

IMF Survey online: The Latvian people seem to still distrust their banks. Has the financial sector been properly stabilized?

Saxegaard: The financial sector is much more stable than it was, though the recent failure of Latvijas Krajbanka highlights the need to improve supervision further.

The good news is that Latvian banks returned to profitability in 2011. The system is liquid and interest rates are low. Banks have resumed some lending, though more to enterprises than to households, but credit growth is still negative because of repayments and loan write-offs, and many people are still struggling to pay back their loans. So, we still see some legacy from the bubble years, but the system is much healthier now.

We think it is important, in the wake of the Krajbanka failure, that the government has committed both to introducing legislation to make it criminal for banks to submit distorted or incomplete information to the financial sector supervisor, and to strengthening the supervisor’s capacity to conduct forensic investigations.

IMF Survey online: What is the IMF’s forecast for 2012 and beyond?

Saxegaard: Last November, during discussions for the final program review, we projected real GDP growth of 2.5 percent for 2012, rising to 4 percent in the medium term. Unfortunately, the uncertainties in the eurozone have been somewhat greater than we thought at the time, so we now see growth in 2012 of around 1.5 percent, rising to 2.5 percent in 2013.

On the plus side, we expect inflation to fall to 2.1 percent in 2012. Provided the government delivers on its commitments, the budget deficit should fall to 2.5 percent of GDP or less, and the Maastricht criteria for adopting the euro will be within reach.

These solid indicators, plus a government debt ratio of less than 50 percent, should also make Latvia a more attractive place for investment.

Griffiths: We shouldn’t generalize too much because all countries are different, but I’ll try to draw some lessons.

First, it’s important to avoid credit booms and large current account deficits. In the boom years, the Latvian government’s approach was to go even faster―to put the “pedal to the metal.” In fact, it would have been better to start putting on the brakes, as getting back out of the ditch has been difficult.

But putting on the brakes during a time when the economy is booming is easier said than done―it requires running large fiscal surpluses (which is tricky politically) and cooperation with foreign bank supervisors to keep credit growth in check. And yet prevention is better than cure.

Second, strong political ownership of the program is key―otherwise it won’t work. It’s important to recognize that this was not simply an IMF-supported program, but more the country’s own program. Working with the Latvian government during the past three years, I saw first-hand that ownership of the program was very strong, especially in the period when the crisis was most severe. Our counterparts were determined to show us and the world that their program would succeed: part of our role was to hold them to the very high standards they had set themselves.

Latvia also shows the importance of front-loading politically difficult reforms. This is what happened with the fiscal consolidation in 2009. If reforms are dragged out or left to future promises, then fatigue sets in and reform becomes more difficult.

IMF Survey online: What lessons has the IMF itself learned from working with Latvia?

Griffiths: It’s been a difficult program that took a lot of effort and involved a lot of cooperation on many fronts. The program was, notably, one of the earliest joint EU-IMF programs, and included other regional partners as well. So there was a lot of learning by doing, especially early on.

But the program had a clear strategy based on keeping the exchange rate peg in line with the authorities’ strategic choice, making sure other policies were consistent with keeping the peg, and then helping Latvia in the medium term to qualify for the euro. So clarity on those goals probably helped the government stick to the program, because it was truly its own program.

We have worked very hard to support the Latvian authorities and help them make their strategy succeed. But without the strong determination of the Latvian government and the Latvian people, it would not have worked.

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